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Stock options are a common form of compensation in the startup world yet they are often misunderstood by both founders and startup employees. In this post, which is based off of content from my book Funded, we’ll go through the mechanics of how stock options actually work.
A stock option is a privilege sold by a company that gives buyers the right, but not the obligation, to buy a stock at an agreed-upon price within a certain period or on a specific date. Stock options are a key part of employee compensation for startups. Stock options help to make up for the added risk taken on by employees and the fact that they often receive below market wages. Stock options also help to align early employees at a company with the interests of shareholders. As the company increases in value, so does the value of an employee’s stock options.
There is no set rule as to what percentage of the company each early employee should be granted in the form of options.
When an employee is given stock options, they are given the option to buy a certain number of shares at a set price, known as the strike price. This option is granted through an Employee Stock Option Plan, or ESOP. Options vest over a period of time while the employee is employed. This period is usually annually or monthly over three to four years. The vesting period is the time that an employee must wait in order to be able to exercise their option.
An option is exercised when an employee notifies the company that they would like to buy the stock at the strike price on their option plan. Once an employee purchases their stock options, they become a shareholder in the company and benefit in increases in company valuation. The more the individual shares increase in value between the strike price and the price at which the option holder ultimately sells their shares, the more money the employee stands to make. This increase in value is known as the spread.
Simply knowing the number of shares and price at which ESOPs are granted won’t tell you very much about their value. In order to make sense out of options, you need to understand what percentage of the company those options represent.
Let’s say there are 1,000,000 shares outstanding, and an employee is granted 1,000 options at $1, and they exercise those options, they will pay $1000 and own 1,000 shares, or .1% of the company. If the company sells for anything above $1,000,000 the employee will profit from their options.
However, if there are 10 million shares outstanding, and an employee is granted 1,000 options at $1, and they exercise those options, they will pay $1,000 and own 1,000 shares, but this time it’s only .01% of the company. The company would need to sell for $10,000,000 for the employee to profit from their options.
Companies don’t have a standard number of shares, so when evaluating the value of a stock option knowing the number of outstanding shares is very important.
There is no set rule as to what percentage of the company each early employee should be granted in the form of options. That said, here are some guidelines that Venture Hacks published relating to equity shares for non-founding new hires in particular roles, based on Silicon Valley standards:
- CEO, 5 to 10%
- COO, 2 to 5%
- A VP, 1 to 2%
- A Lead Engineer, 0.5 to 1%
- A Engineer with 5+ years experience, 0.33 to 0.66 %
- A Manager or Junior Engineer, 0.2 to 0.33 %
Shares set aside to be granted to employees as stock option are listed on the company’s cap table in the form of an option pool. Employees who get into the startup early will usually receive more options, at a lower strike price, than employees who arrive later. When added to the cap table the option pool dilutes all other shareholders on a pro-rata basis dependent on the size of the pool.
The size of your option pool should match your hiring plan, and the options you intend to give out to those expected hires.
If an option pool does not already exist, option pools are generally carved out when company is raises money because investors don’t want to share in the dilution after they become shareholders. The average option pool for a startup is 10 percent per round of financing with exceptional cases being 5 percent or 15 percent. The size of your option pool should match your hiring plan, and the options you intend to give out to those expected hires. Generally, you want to negotiate for a smaller option pool, because it decreases your dilution.
Fred Wilson of Union Square Ventures discussed option pool size in one of his blog posts, noting that negotiation over option pool size is really just a negotiation around price. Investors see larger option pools as a way to get a lower price, protecting themselves from future dilution by stretching out the time before a new option pool needs to be created.
If stock options in an option pool are not granted or exercised, the shares are redistributed on a pro-rata basis to all shareholders. Some entrepreneurs create a shareholder provision that unissued options will be returned to the founders and angels, as opposed to institutional investors – a bonus on an exit. If an investor objects to the provision and insists on distribution to all shareholders it becomes a non-critical negotiation point you can agree to. By agreeing to this requirement, it is possible the new investor will be lenient in other matters.
Another term related to stock option that you might come across is Warrants. Warrants are similar to stock options in that they are a contractual right to purchase shares at a particular price, for a particular period of time. Warrants are different in that they are generally granted as part of an investment transaction, unlike options that are generally granted as compensation to employees or contractors. As such warrants do not have the vesting and are generally applied to the most recent share class as opposed to common shares.
Editor’s Note: This entry is an excerpt from Katherine Hague’s new book – Funded: The Entrepreneur’s Guide to Raising Your First Round. The book is now available through O’Reilly Media.
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